I provide a justification of intellectual property rights as a source of static efficiency
gains in manufacturing, rather than dynamic benefits from greater innovation.
I develop a property-rights model of a supply relationship with two dimensions of non-contractible
investment. In equilibrium, the first best is attained if and only if ownership
of tangible and intangible assets is equally protected. If IP rights are weaker, the
organization of the firm is distorted and efficiency declines: the final producer must
either integrate her suppliers, which prompts a decline in their investment; or else risk
their defection, which entails a waste of her expertise. My model predicts a greater
prevalence of vertically integrated manufacturers where IP rights are weaker, and a
switch from integration to outsourcing over the product cycle. Empirical evidence on
the international supply chains of multinational companies bears out both predictions.
As a normative implication, I find that IP rights should be strong but narrowly defined,
to protect a business without holding up non-competing derivative innovations.